BNA Pension and Benefits Blog

Actions to Consider on Uncertain Tax Positions

So, if you have been reading all week, this posting will make sense.  If you have not read all week go down to the Tuesday post and read back through the week. Since many readers of this blog work within the benefits department of a company, are consultants or attorneys, they may not follow financial reporting standards that are not aimed specifically at compensation or benefit considerations. FASB Interpretation 48 is a general pronouncement regarding the need to measure, report and disclose uncertain tax positions. Public companies are already dealing with this.  But the standard applies to any income tax position and any enterprise – taxable or tax-exempt, that might owe income taxes. If a tax return position does not meet the more likely than not standard, the company must measure the potential impact on their tax liability and adjust their financial statements accordingly.  There is also additional financial statement disclosures required relative to this standard.  This standard applies to financial reporting periods beginning after December 15, 2006. Measurement and reporting applies to uncertain tax positions taken in any open tax year.

The good news is that the required disclosure is not specific by item. The bad news is that the auditor needs to examine each significant uncertain tax position and draw a conclusion regarding the certainty of success on that position. Auditor’s work papers are not subject to privilege. So the action point is to anticipate these issues and be prepared or help your clients get prepared to defend those tax positions that might otherwise be considered uncertain. If this work is done now, well in advance of when the auditor shows up, everyone is likely to be a lot more comfortable through the implementation of this new standard.

Benefit Plan Issues under FIN 48

We started this discussion in explaining that FIN 48 related to uncertainties in income taxes.  So the obvious question is:  Why worry about a tax-exempt benefit plan?

Well, the good news is, at least in my opinion; you generally will not need to worry about issues that would cause the plan to lose its exempt status.  FIN 48 includes a provision for recognized administrative systems that would permit the client’s tax position, even though it might otherwise appear uncertain. In my opinion (as far as it has developed to date), EPCRS should constitute such an administrative scheme. There is a recognized system to allow a plan to retain its exempt status in spite of potentially questionable practices, so it the majority of plans there should not need to be any estimate of a tax liability based upon qualification violations.

That doesn’t get benefit plans totally off the hook from analysis under this standard, however. Consider:

1. Funded welfare benefit plans:  Are the assumptions made about any reserve for incurred by not reported medical claims or post-retirement benefits reasonable or is an unrelated business income tax due?
2. Any funded benefit plan: 
   1. Is the trust invested in assets that could be considered to generate unrelated business income taxes?
   2. If the trust is invested in assets that trigger unrelated business income taxes, are there any material uncertain tax positions taken by such pass-through entities such as partnerships or trusts?
3. ESOPs of S corporations:
   1. Are the securities held by the ESOP qualifying employer securities? 
   2. Are the assumptions used in measuring synthetic equity for purposes of the broadly held test of IRC Section 409(p) reasonable?

Remember, if a plan has more than 100 (120) eligible participants, it is subject to audit.  Those plans are going to have to deal with this new standard, just like the plan sponsor. But, the measurement of materiality is generally lower for the benefit plan audit, than it is for the sponsor’s audit.  Thus, though these issues may be less frequently encountered in plans, when encountered they will likely be more significant.

Tomorrow we will talk about what this stuff really means to the client.

Executive Compensation Considerations

This section highlights the frustration of any blog. This discussion is based on the prior discussion of new FASB Interpretation 48 – Accounting for Uncertainty in Income Taxes.  So, you need to read that section before you read this discussion. These postings are aimed at raising the awareness of the readers to compensation matters which may be considered “uncertain” under the new financial reporting rules and, as such, should trigger questions from the employer.

FIN 48 focuses attention on tax return positions. To sign a tax return, the position only needs a realistic possibility of success. That is a one in three standard.  FIN 48 requires more likely than not, which is something better than a 1 in 2 chance of success. This focuses a lot of attention on tax return positions that involve a degree of subjective decision making.  Those issues are very common when it comes to executive compensation.

1. IRC Section 162(m) generally limits the deduction of compensation for certain persons employed by a publicly traded enterprise to $1 million. That is an objective standard.  But there are many areas under Section 162(m) that are subject to judgment:
   1. Where equity compensation is included was the fair value actually determined at grant date? Was the determination of fair value reasonable?
   2. Has there been sufficient disclosure of the terms of the option plan?
   3. Can the performance pay exception be relied upon?
2. IRC Section 280G imposes very significant limits on the deduction of compensation triggered by a change in control. Like, 162(m), this includes objective and subjective criteria.
   1. Are amounts paid properly classified as reasonable compensation for services rendered following the change in control?
   2. Has base year compensation been measured properly?
   3. Has the exception for a small business corporation been properly applied?
3. Equity compensation takes many forms – options, restricted stock, phantom stock, stock appreciation rights and others.
   1. Was a transfer actually made?
   2. Was the date that the property was no longer subject to a substantial risk of forfeiture properly determined?
   3. Was the property valued correctly?
   4. Have any lapse or nonlapse restrictions been identified and considered?
4. Cash deferred compensation should be easy, but even here there are issues to consider.
   1. If services during the deferred period were rendered to multiple entities – who gets the deduction upon payment?
   2. Is it deferred compensation or a restricted property award? There are somewhat different deduction timing rules under Section 404 versus Section 83.
   3. When did “vesting” occur relative to payment? Is the payment truly deferred compensation?

Please do not assume that this is a comprehensive list. It would be nice if the readers would add other issues to this list to expand the idea of the kind of compensatory devices that are subject to evaluation under this standard.

Tomorrow, we will cover how the standard applies to benefit plans that are subject to a financial statement audit.

Uncertain Tax Positions and Compensation

As if there isn’t enough change going on – revised SEC disclosures, potentially 400 pages of “final” 409A regulations, revised accounting standards for equity compensation, proposed legislation limiting the amounts of deferred compensation, ad nauseum. Benefit’s advisors must also deal with subtle and unexpected changes, like “FIN 48.”

Like many other recent accounting standards, this new requirement has developed in response to what many perceived as “abuses” in business tax and accounting practices. You may agree or disagree with that perspective, but the reporting position is now fact and you or your clients will have to deal with it.

Basically what this standard requires is that each entity subject to audit under generally accepted accounting principles assess their income tax position on all material items of income and expense.  Any position taken on the tax return must generally satisfy a more likely than not standard of success. In assessing the likelihood of success, it is assumed that the applicable tax enforcement group is reviewing the position, has all the facts available and is familiar with the applicable law.

If a tax return position does not meet the more likely than not standard, the company must measure the potential impact on their tax liability and adjust their financial statements accordingly. There is also additional financial statement disclosures required relative to this standard.

This statement has very comprehensive impact. It applies to any entity that MAY owe a tax liability. That means it can apply to taxable entities, certain pass-through entities and tax-exempt entities (either because of unrelated business tax issues or the potential loss of tax-exempt status.)  That means that this standard applies not just to employers, but also to their benefit plans. That is an important point because an issue may be immaterial to the employer, but significant to the plan.

The standard is currently effective for publicly traded companies and will apply to private enterprises for year beginning on or after December 15, 2006.  However, the standard does effectively apply to positions taken on returns that are currently in process, as the liability assessment is based upon all open years, not just the current year.  Also, in assessing any potential liability, the amounts of interest or penalties are also to be included.

This posting is not intended as a detailed analysis of the new standard. This is not the appropriate medium for that.  Most accounting firms have been doing web based training on this standard and you can check those out to get detailed information. What I intend to cover over this week is various areas of compensation planning that can result in issues that must be reviewed for potential measurement under this standard. There are many, many areas related to compensation and benefits.  Some of which are so familiar, that we may have forgotten that they do not reflect settled law where it is easy to get to a more likely than not standard. Also, this will help explain some of the calls you may be receiving from your clients.

Caveat:  My background is largely private companies. I am hoping that other members of the advisory board will chime in on public company concerns.

The Basics

1. Reasonable compensation:  The deduction under IRC Section 162 is limited to reasonable compensation for services. Amounts paid in excess of this reasonable limit are not deductible. How much work have you or your client done to get comfortable that the level of compensation being paid is reasonable at a more likely than not standard of success?
2. Deduction for accrued bonuses:  The temporary regulations under IRC Section 404, as well as the proposed regulations under IRC Section 409A, provide a haven from the classification of a payment as deferred compensation, if it is paid within 2 ½ months of the end of the tax reporting period. But, many employers take that as a safe harbor and fail to take other steps to demonstrate that the bonus was, in fact, accrued as of year-end. If reasonable, the risk associated with this matter may just be a timing different, but it still must be analyzed under FIN 48.
3. Entertainment Expenses:  IRC Section 274 sets some very rigorous and mechanical standards controlling the deductibility of travel and entertainment expenses. Amounts outside of these limits are not deductible.  Frequently employer’s programs fail to capture this information and apply the appropriate limits on the tax return.  There are also some soft issues in this area with respect to the allocation of costs, etc.

Tomorrow we will cover some of the executive compensation issues.

As 401(k) plans become the major source of retirement savings,  Congress, GAO, DOL and the SEC are all turning their attention to the issue of 401(k) fees. Last fall, Gao issued a reprt on Changes Needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees at the request of Congressman George Miller, now Chair of the House Education and Labor Committee.  Last week, the Committee held a hearing on "Hidden 401(k) Fees Undermining Retirement Security?"  If you missed the hearing, you can view it on line at the Committee's website, where the written testimony of the witnesses is also posted.

The DOL has indicated that they will be launching a number of new initiatives to increase disclosure of 401(k) fees, particularly the payment of indirect fees to service providers. The DOL has already proposed a revision of  Schedule C of the Form 5500 which would require annual disclosure of indirect fees. Recognizing that plan fiduciaries often have difficulty getting information about indirect fees, the Department is planning to propose an amendment to the statutory prohibited transaction exemption that permits service providers to be paid (ERISA section 408(b)(2)) to require service providers to provide information about indirect compensation so that plan fiduciaries can determine if their total fees are reasonable. The Department is also expected to issue a request for informtion about 401(k) disclosure of fees, both direct and indirect, to plan participants.

Meanwhile, in a speech to the ABA Business Law Section last week, Andrew Conohue, Director of the SEC's Division of Investment Management, indicated that the SEC is working with the DOL to determine how fee disclosure should be made to 401(k) plan participants. He also indicated that the Commission staff is reviewing the rule that permits mutual funds to pay 12b-1 fees.

Plan fiduciaries should be continuing to request information about indirect fees from service providers such as investment managers, investment consultants, recordkeepers and trustees to determine whether the fees paid by their 401(k) plan are reasonable. Since many fees paid by 401(k) plans are asset based, fiduciaries should review the total paid annually as plan assets grow. Also, fiduciaries should move to institutional shares of mutual funds as their investments reach the minimums for such shares. Finally, fiduciaries should benchmark the fees they are paying against industry averages.

Fiduciaries shouldn't lose sight of the fact that the key is the return participants are getting net of fees, so fees shouldn't be the only consideration. However, compared on a net basis, lower fees will often result in better performance.